By Ven Ram, Bloomberg Markets Live reporter and strategist
How much of policy tightening is too much? With the major central banks around the world already having raised their benchmark rates by the most in decades, it’s natural that the question is being asked.
In fact, it seems that it was a point of discussion at the European Central Bank’s meeting last month, though such concerns were considered premature. When interest rates go from being the most accommodative they have perhaps ever been to a regime where they need to curb the worst bout of inflation in decades, central banks have to make up for lost time. Could it be that policy mandarins may have to raise rates to the extent of perpetrating a crisis in a vulnerable corner of the market?
Perhaps — but don’t blame the tightening. Instead, blame the ultra-loose policy accommodation that preceded it. At least, that’s the conclusion of just-released research by the San Francisco Fed.
Among other things, the paper says:
“A loose stance over an extended period of time leads to increased financial fragility several years down the line. The source of this fragility is associated with swings in those financial variables that have been identified by the literature as harbingers of financial turmoil. Policymakers should take the dangers imposed by keeping policy rates low for long seriously, and thus weigh the potential short-run gains of loose monetary policy against potentially adverse medium-term consequences.”
This is something discussed in ZeroHedge for much of the past decade (see In Every Market Shock Since 2013 Central Banks Have Stepped In To Protect Markets from 2017; Beware An "Instability Cascade": One Bank Warns That Stocks Are About To Hit Record Fragility from 2022).
That should cut close to the bone for many central banks that willingly plied the markets with oodles of cash and then some after having already slashed rates to ultra-low levels. The Bank of England’s experience is a case in point. When rates touched the basement bottom before the inflation genie was uncorked, the housing markets were intoxicated, and few thought of the perils of an eventual upshot in interest rates. Yet, it’s now a huge issue for many domestic homeowners, and the BOE — already playing catch-up in its fight against inflation — seems to be caught between a rock and a hard place.
And let’s not forget that the crisis that beset the UK pension fund industry last year was ultimately fostered by ultra-low rates that spurred investors to seek out leveraged swaps. But the BOE isn’t the only one caught in a bind by any stretch of imagination.
If it feels like too much tightening, it is because central banks are settling two outstanding bills at once: one for the excess indulgence of the go-go days, and one for being asleep at the wheel when inflation started showing up.
And if there is a single lesson to take away from the current inflationary backdrop for central banks, it is perhaps that pumping money into the economy at the first hint of distress comes with unacceptably high costs. As the paper says, “Financial crises are predicted by loose monetary policy several years ahead.”